1. From financial options to real options1. Introduction to real options Prof. André Farber Solvay Business School ESCP March 10,2000 Introduction to real options

2. Valuing a company: • Standard approach: V = PV(Expected Free Cash Flows) • Free Cash Flow = CF from operation - Investment • Risk adjusted discount rate • Another approach: V = NOPAT/r + PVGO • NOPAT : net operating profit after taxes • PVGO: present value of growth opportunities • = present value of future NPV • Does it apply to Yahoo or Amazon.com? Introduction to real options

3. Making Investment Decisions: NPV rule • NPV : a measure of value creation • NPV = V-I with V=PV(Additional free cash flows) • NPV rule: invest whenever NPV>0 • Underlying assumptions: • one time choice that cannot be delayed • single roll of the dices on cash flows • But: • delaying the investment might be an option • what about flexibility ? Introduction to real options

4. Portlandia Ale: an example • (based on Amram & Kulatilaka Chap 10 Valuing a Start-up) • New microbrewery • Business plan: • €4 million needed for product development (€0.5/quarter for 2 years) • €12 million to launch the product 2 years later • Expected sales € 6 million per year • Value of established firm: €22 million • (based on market value-to-sales ratio of 3.66) Introduction to real options

5. DCF value calculation Introduction to real options

6. But there no obligation to launch the product.. • The decision to launch the product is like a call option • By spending on product development, Portlandia Ale acquires • a right (not an obligation) • to launch the product in 2 years • They will launch if, in 2 years, the value of the company is greater than the amount to spend to launch the product (€12 m) • They have some flexibility. • How much is it worth? Introduction to real options

7. Valuing the option to launch • Let use the Black-Scholes formula (for European options) • At this stage, view it as a black box (sorry..) • 5 inputs needed: Call option on a stockOption to launch Stock price Current value of established firm Exercise price Cost of launch Exercise date Launch date Risk-free interest rate Risk-free interest rate Standard deviation of Volatility of value return on the stock Introduction to real options

8. Volatility • Volatility of value means that the value of the established firm in 2 years might be very different from the expected value Introduction to real options

9. Using Black Scholes • Current value of established firm = 14.46 • Cost of launch = 12.00 • Launch date = 2 years • Risk-free interest rate = 5% • Volatility of value = 40%  • and…magic, magic…..value of option = € 4.96 Introduction to real options

10. The value of Portlandia Ale • (all numbers in € millions) • Traditional NPV calculation PV(Investment before launch) - 3.83 PV(Launch) - 10.86 PV(Terminal value) +14.46 Traditional NPV - 0.23 • Real option calculation PV(Investment before launch) - 3.83 Value of option to launch + 4.96 Real option NPV + 1.13 Introduction to real options

11. Let us add an additional option • Each quarter, Portlandia can abandon the project • This is an American option (can be exercised at any time..) • Valuation using numerical methods (more on this later..) • Traditional NPV calculation Traditional NPV - 0.23 • Real option calculation PV(Investment before launch) - 3.83 Value of options to launch and to abandon + 5.57 Real option NPV + 1.74 Introduction to real options

12. Real option vs DCF NPV • Where does the additional value come from? • Flexibility • changes of the investment schedule in response to market uncertainty • option to launch • option to continue development Introduction to real options